Three Forces Squeezing Energy Profits

Generating utilities are experiencing an unprecedented squeeze on margins. Wholesale power prices have fallen off the cliff and it appears average prices will remain low for the foreseeable future.

Of course, there will continue to be price spikes. Price spikes into the hundreds of dollars will appear for a few hours on hot summer days. Price spikes will be newsworthy in regions like New England, Texas and California, where there is a capacity shortage. Investors should not overreact to these spikes. For the most part, they no longer matter.

Price spikes only make a dent in a generator's earnings. Power generation is a round-the-clock operation where high prices are offset by low prices. The average price will dictate earnings.

In 2012, the average price of wholesale power fell. There are several reasons for the decline. The biggest is deregulation and the emergence of power markets. Hundreds of times each day, these markets match energy supplies with consumer demand to set market prices.

For generating utilities, energy supplies have been growing while demand has been falling. See graph:

Many commentators claim the source of the problem is cheap natural gas. It is a factor. But the graph tells a different story. Energy production decreased as generating capacity increased. To make matters worse, it appears consumers are not responding to lower price signals by consuming more.

Appearances are deceiving. Consumers are responding to market signals. There is a lot more going on under the hood other than natural gas. In fact, there are three simultaneous forces at work, all of which affect power markets:

Energy markets

Energy efficiency

Renewable energy

In North America's ten deregulated markets, wholesale power prices for power are set by market auctions. When supplies meet demand, a price is set and all successful bidders earn that market-clearing price. The market constantly rewards the cost efficient and punishes the inefficient, which puts downward pressure on wholesale energy prices. As these markets mature, the pressure to lower prices will only increase.

Under new Federal Energy Regulatory Commission rules, energy efficiency prices are also set by the power markets. In fact, energy efficiency competes directly against power plants and power plants compete directly against energy efficiency.

This new arrangement seems odd. To help understand the market, consider the fact that under FERC rules, energy efficiency has become a commodity that will trade in the power markets.

It gets more interesting. The intent of FERC is that the energy efficiency commodity will become completely fungible with the energy commodity in the markets. That is one of the ideas behind the installation of smart meters.

In fact, for capacity-starved regions like the Northeast, Texas and California, energy efficiency is the only practical answer to the troubling question where to attract new generation. The answer is they do not need to attract new power plants; energy efficiency and the markets should shave demand and peak prices. This will have the effect of adding virtual supplies and reducing prices.

Energy efficiency is not the only actor that helps keep prices low. Real Money readers already know wind and solar power resources reduce market-clearing prices because they, like energy efficiency are cost leaders (not necessarily price leaders.) Markets reward cost leaders. As such, energy efficiency, wind and solar resources will only grow over time and keep market pressure on the traditional generating utilities.

Investors should avoid manufactures of renewable energy equipment and focus on companies that own wind and solar farms. Owners of wind and solar farm are making solid returns. This includes Xcel Energy (XEL), NextEra Energy (NEE), Duke Energy (DUK) and even Exelon (EXC).

Unfortunately, there are losers. Old-fashioned steam generating utilities are not cost leaders. An example is Entergy (ETR). Their merchant fleet of nuclear plants will be among the first to experience growing competition from energy efficiency in two grids: ISO New England and New York ISO. As wind and solar resources grow, wholesale prices Entergy uses to set margins will slide further. Lower margins mean lower earnings.

Investors should be skeptical when they hear utility executives argue that higher power prices will arrive in 2015. If a utility executive is looking to the past to predict the future, they are in for a big surprise. In the past, energy efficiency did not exist as a regulated commodity. In the future, energy efficiency will become a major competitor.